Guest Post: Optionality Clauses Permissible in FDI Instruments – the Heydays for Exit Rights

[This post is contributed by Nidhi Bothra of Vinod Kothari & Co.
She can be contacted at [email protected].
This is a continuation of a previous
on this topic, and supplements the analysis in that post.]
The optionality clause in equity shares/ compulsory convertible
debentures/ preference shares has been a gray area from the regulatory perspective
in India for years. These instruments did not find their eligibility under the
FDI norms or Securities Contract (Regulations) Act, 1956 (SCRA) provisions and
did not have the nod from SEBI and RBI either. The position for such
instruments remained ambiguous till SEBI’s notification on enforceability of
pre-emption right and call and put options in securities of Indian companies
and the recent RBI notification that followed thereafter which expressly granted
eligibility to such instruments under the FDI regulations. This post elucidates
on the latest developments in this segment and its impact thereof.


RBI legitimizes
optionality clause instruments for FDI
Very recently, RBI vide its notification
dated 9th January 2014 issued the pricing guidelines for FDI
instruments with optionality clauses. RBI has permitted issuance of equity
shares or compulsorily convertible preference shares/ debentures with
optionality clauses to foreign investors under the extant FDI scheme with a
view that such optionality clauses will permit exit mechanism for the
investors. The condition precedent to such eligibility is that such instruments
should not provide for an assured return as it gets a color of debt and not
equity or equity type investment and is subject to certain conditions as well. The
provisions of the optionality clauses are made subject to the following
a. Minimum lock-in of one year or such
higher lock-in period as prescribed under FDI regulations. The lock-in shall be
effective from the date of allotment of such shares/ debentures.
b. Post the lock-in period the non-resident
investor shall be allowed to exercise the option to exit without any assured
return, provided:
i. In case of listed companies, the non-resident investor can exit at the
prevailing market prices at a recognised stock exchange.
ii. In case of unlisted companies, the non-resident investor shall be
eligible to exit at a price not exceeding that arrived at on the basis of
Return of Equity (RoE[1])
as per the last audited balance sheet of the investee company.
c. Investment in compulsorily convertible
debentures/ preference shares can be transferred at a price worked out as per
internationally accepted pricing methodology at the time of exit duly certified
by a Chartered Accountant or SEBI registered merchant banker.
As per the notification all
existing contracts will have to qualify with the above conditions to be FDI
So there are multiple combinations
that may work for foreign investors when they invest through such instruments
whether with or without options. The situation that emerges from this
notification and under the extant FDI policy with regard to equity shares and
convertible instruments is discussed below.
When the foreign investor has to
buy the equity shares with or without option, in case of listed companies, they
can buy the shares at a price not less than as determined as per the SEBI
pricing guidelines and in case of unlisted companies the foreign investors can
buy shares fair valued as per DCF method done by SEBI Merchant Banker or
Chartered Accountant.
The variation in the exit pricing
is what makes several combinations mechanisms possible for investors. In case
the foreign investors investing in equity shares of listed company with
optionality clause, the investor will buy the shares at a price determined by
SEBI pricing guidelines and can sell at the prevailing market price at a
recognised stock exchange. In case the foreign investors invest in equity
shares of unlisted company with optionality clause, the investor will buy
shares at a fair valued price as per DCF method but will sell shares at a price
arrived on the basis of RoE of the company as per last audited balance sheet.
In case of compulsorily
convertible instruments, when the foreign investor has to buy the compulsorily
convertible preference shares/ debentures with or without option, in case of
listed companies, they can buy the instruments at a price determined as per the
SEBI ICDR guidelines and in case of unlisted companies the foreign investors
can buy instruments fair valued as per DCF method done by SEBI Merchant Banker
or Chartered Accountant.
In case of exit mechanism
available after the RBI’s notification, if the instrument were issued with
optionality clause, the instrument is to be sold at a price arrived as per the
internationally accepted pricing methodology, whereas if the instruments were
issued without optionality clause, the instrument is to be sold at a conversion
price not lower than fair value arrived at the time of issuance.
Several observations that arise
from the RBI notification are as follows:
a. In case of investment in equity shares of
unlisted company, where the investor has to purchase at a price arrived at
future projections but will have to exit at prices based on or linked to RoE as per last audited balance sheet. The observations
i. The returns at the time of exit are linked to RoE and RoE itself.
Hence the shareholders’ agreement will have to clearly lay down the exit price
computation linked to RoE.
ii. If the RoE based price does not render the returns expected by the
investor, the investor will let the option expire and shall sell the shares at
the market price which may be reflective of the fundamentals of the company.
This gives investors flexibility of choosing mode of exit within the same
b. In case of compulsorily convertible debentures/
preference shares:
If the instrument is issued with option the foreign investors have more
flexibility in choosing the mode of valuation of the instrument as long as it
is internationally acceptable methodology.
These options now available to the
foreign investors has made the investment domain open and available for further


Applicability of
Companies Act, 2013
Section 58(2) of the Companies Act provides for free
transferability of shares or interest of a member, in case of a public company.
However, the proviso[2]
to the section seeks to give recognition to restrictions on transfer in
shareholders’ agreements, thereby covering preferences like right of first
Further under section 194 of the Companies Act, 2013 there is
a prohibition on forward dealings in securities of company by directors or key
managerial personnel. The section states that the director or key managerial
personnel shall not have the right to call for delivery or make delivery of any
shares or debentures in the company, its holding, subsidiary or associate
company. The contravention with the provisions of this section are severe and
are punishable with imprisonment which may extend upto 2 years or fine which
shall not be less than Rs. 1 lac which may extend upto Rs. 5 lacs or with both.
It is noteworthy that the express prohibition is on the
directors and the key managerial person and not on the relatives of such persons.
Further, writing of a call is not barred under this section also, if the right
to call for delivery or right to make delivery is at market price then such
transaction is not barred by this section.
Typically for such investors exit mechanisms include initial
public offer, buy-back of shares by the investee company, optionality clauses
(call/ put options), tag along/ drag along rights, trade sales etc. However the
optionality clause renders flexibility in devising the strategy for investment
for the foreign investors. For instance a call option allows the investors to
increase the stake in the investee company and is useful where the investors
are actively involved in the functionality and operations of the company. The
call option allows foreign investors to increase their shareholding when
desired or as permissible under the regulations. Likewise put options permits
foreign investors to reap the benefit of their investments when the valuation
of the investee company increases.
The phase from 2006 – 2010 saw several private equity/ angel
investors investing in Indian entrepreneurs. The investment deals were brimming
with opportunities for private equity investors, eyeing angel investments in
India increasingly in 2009-10 and first half of 2011. Several investments deals
were undertaken with pre-emption rights/ optionality clauses as commonly used
exit options. India had become a hot destination for global private equity
investors to expand their allocations to India next only to China and the
global financial crisis of 2008 aided in channelizing the funds to India. This
continued till the first two quarters of 2011. However the situation changed
drastically, when the regulators raised concerns on issuance of equity shares/
compulsory convertible debentures/ preference shares with optionality clause
and put an express bar on such instruments under the FDI norms in 2011. There
was a 25% decline in private equity investments in the first three quarters of
2012 as compared to the similar period in 2011. With regard to exits, while the
volumes of exit increased during 2012, the exit values fell substantially from
USD 1.8 billion to USD 1.1 billion[3].
This was later withdrawn due to sharp criticism from the investors’ community.
While in the recent times the importance of initial public
offering as an exit mechanism has greatly diminished considering the state of
the capital markets; with the permissibility of such instruments and
pre-emption rights along with the amendments in the Companies Act, 2013 will
pave way for these investors to keenly consider other exit options. The
relaxation in the FDI norms is an attempt to facilitate FDI inflows into the
country which had dropped substantially in 2013[4]
and these amendments seem to be supportive to the cause from the regulatory
perspective. Also what is paramount to the investors is some clarity in
regulations which was missing all this while; hence the RBI notifications
probably will be welcomed by the investors’ community.

– Nidhi Bothra

[1] RoE
shall mean profit after tax/ net worth; networth would include paid-up capital
and all free reserves.
[2] The proviso to Section 58(2) of the Companies
Act, 2013 stipulates “any contract
or arrangement between two or more persons in respect of transfer of securities
shall be enforceable as a contract
[4] FDI in
India dropped by 15% between April-October, 2013

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.


  • Two questions that come to mind: (i) Would the pricing guidelines in the notification apply in addition to the existing pricing guidelines with respect to such transfers (DCF)? I would assume so. (ii) How exactly do you determine price 'based on Return on Equity'?

  • Dear Umakanth sir,

    The relevant RBI circular says that optionality clauses may henceforth be allowed in equity shares and compulsorily and mandatorily convertible preference shares/debentures to be issued to a person resident outside India under the Foreign Direct Investment (FDI) Scheme.

    The optionality clause will oblige the buy-back of securities from the investor at the price prevailing/value determined at the time of exercise of the optionality so as to enable the investor to exit without any assured return.

    There is a minimum lock-in period of one year or a minimum lock-in period as prescribed under FDI Regulations, whichever is higher (e.g. defence and construction development sector where the lock-in period of three years has been prescribed). The lock-in period shall be effective from the date of allotment of such shares or convertible debentures or as prescribed.

    The key words "issue", "buyback" and "allotment" appear to provide an understanding that the optionality clause could be attached only in the event of issuance of shares by an investee Indian company to its investor, and optionality clause is in violation of FDI guidelines in the following circumstance:

    An Indian company issues shares without an optionality clause to a foreign private equity investor B. At the time of a secondary sale of the said shares from B to another foreign private equity investor say, C, C insists for a put option on the promoters of the Indian company.

    Kindly give your inputs on the above stated proposition. Thank you.

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